A Buy-Side Guide to Regulatory and Transactional Issues Related To Derivatives and Repurchase Agreements

The International Swaps and Derivatives Association (ISDA) has published the first in a series of guidelines for what it colloquially refers to as “smart derivatives contracts” (the Guidelines).* A smart derivatives contract is a derivative that incorporates software code to automate aspects of the derivative transaction and operates on a distributed ledger, such as a blockchain. This series of papers is intended to “provide high-level guidance on the legal documentation and framework that currently governs derivatives trading, and to point out certain issues that may need to be considered by technology developers when introducing technology into that framework.”

Derivatives have long been thought to be a fitting use case for smart contract solutions. It is little surprise that derivatives industry incumbents and startups alike are working on novel smart contract solutions to facilitate the execution and clearing of derivatives. Smart derivatives contracts have the potential to create significant efficiencies in the derivatives market by automating the performance of obligations and operations under a derivatives contract. Derivatives settlement is largely reliant upon conditional logic informed by certain data points that can be made available via oracle. Continue Reading

FINRA is issuing this Notice to announce that FINRA is extending by an additional year, until March 25, 2020, the effective date of the margin requirements that otherwise would have become effective on March 25, 2019.

As we explained in a January 29th post, the purpose of this delay is to allow FINRA to consider whether any revisions to the TBA margin requirements are appropriate. According to Regulatory Notice 19-05,

FINRA’s consideration of potential revisions is ongoing.

In other words, the text of the revisions (if any) will be published in the future.

Both the SEC and FINRA recently released their 2019 Examination priorities, (available here and here) highlighting primary areas of focus for 2019. While there are no surprises, there are some items that have a unique twist that warrant attention. In this post we provide an overview of the regulators focus on Reg SHO and short selling.

Both regulators will continue to focus on aspects of Reg SHO compliance. FINRA will be focused on the exception to the netting required in Rule 200(c). Rule 200(c) states that a person shall be deemed to own securities only to the extent that he has a net long position in such securities. Rule 200(f) grants an exception to the netting requirement by allowing broker-dealers to break into independent aggregation units for purposes of determining the trading unit’s net position. To take advantage of the exception, broker-dealers must demonstrate four criteria to establish separateness and independence. Of note, only broker-dealers can rely on 200(f). During the adoption of Reg SHO Rule 200, commenters requested that the SEC extend the relief beyond broker-dealers, and the SEC declined to do so, stating that the lack of oversight by a self-regulatory organization might facilitate the creation of units that are not truly independent or separate. The SEC will be looking at Reg SHO compliance more broadly in the context of microcap securities. Continue Reading

Financial Industry Regulatory Authority, Inc. (“FINRA”) is filing with the Securities and Exchange Commission (“SEC” or “Commission”) a proposed rule change to extend, to March 25, 2020, the implementation date of the amendments to FINRA Rule 4210 (Margin Requirements) pursuant to SR-FINRA-2015-036, other than the amendments pursuant to SR-FINRA-2015-036 that were implemented on December 15, 2016.

FINRA has indicated that it will file the proposed rule change with the Securities and Exchange Commission (“SEC”) with a request for “immediate effectiveness,” which means that FINRA is recommending to the SEC that the deferred implementation date will become effective immediately upon filing of the rule change by FINRA with the SEC. Continue Reading

On December 21, 2018, the U.S. Securities and Exchange Commission (“SEC”) announced enforcement actions against two robo-advisers, Wealthfront Advisors LLC (“Wealthfront”) and Hedgeable Inc. (“Hedgeable”), for making false statements about investment products and publishing misleading advertising. “Robo-advisers” are investment advisers that provide automated, software-based portfolio management services. In a press release related to these actions, the Chief of the SEC Enforcement Division’s Asset Management Unit stated that “[t]echnology is rapidly changing the way investment advisers are able to advertise and deliver their services to clients … [but] [r]egardless of their format … all advisers must take seriously their obligations to comply with the securities laws, which were put in place to protect investors.” These enforcement actions, the first by the SEC against robo-advisers, highlight the nuanced risks and requirements for robo-advisers under U.S. securities laws. Read the full article on our sister blog Asset Management ADVocate.

On September 19, 2018, ISDA published the ISDA Benchmarks Supplement (the “Supplement”) to enable parties to include fall back provisions in their trades if a benchmark ceases to be provided by the administrator to the benchmark or if a regulator of the administrator, the applicable central bank or applicable resolution authority announces that the administrator shall cease to provide a benchmark (an “index cessation event”). The Supplement covers the following ISDA definitions booklets:

2006 ISDA Definitions;

2002 ISDA Equity Derivatives Definitions;

1998 FX and Currency Option Definitions;

2005 ISDA Commodity Definitions.

The Supplement also introduces the concept of an “Administrator/Benchmark Event” which applies if a benchmark or an administrator is not approved and therefore cannot be used by the parties in accordance with applicable law. Continue Reading

On the heels of remarks by his U.S. Commodity Futures Trading Commission (“CFTC”) counterpart, U.S. Securities and Exchange Commission (“SEC”) Chairman Jay Clayton recently commented on ongoing benchmark reform and the transition to the Secured Overnight Financing Rate (“SOFR”). As we noted earlier this week, Chairman J. Christopher Giancarlo of the CFTC recently advocated for the adoption of SOFR as the appropriate replacement for LIBOR and added that the CFTC is already working on the transition. He implored market participants and firms to immediately begin transacting in SOFR derivatives for the health of the transition.

In remarks on December 6, 2018, Chairman Clayton mentioned the transition away from LIBOR as a market risk that the SEC is currently monitoring. For Chairman Clayton, the key risk stems from the fact that there are approximately $200 trillion in notional transactions referencing the U.S. Dollar LIBOR and that more than $35 trillion will not mature by the end of 2021, when banks currently reporting information used to set LIBOR are scheduled to stop doing so. Listing potential issues with a transition away from LIBOR, Chairman Clayton raised questions such as what happens to the interest rates of the instruments that will not mature before 2021 but reference LIBOR? Does an instrument’s documentation include any fallback language? If not, will consents be required to amend the documentation? Continue Reading

On November 29, 2018, in remarks before the 2018 Financial Stability Conference in Washington, D.C., Chairman J. Christopher Giancarlo of the U.S. Commodity Futures Trading Commission (“CFTC”) supported the adoption of the Secured Overnight Financing Rate (“SOFR”) as the new benchmark for short-term unsecured interest rates. SOFR is currently produced by the Federal Reserve Bank of New York (“New York Fed”) and is based on transactions in the repurchase agreement transaction (“repo”) markets. Chairman Giancarlo’s statements and support of SOFR come on the heels of a series of market and regulatory developments relating to benchmark reform.

Since 2017, regulators and financial market industry leaders have been working to design alternative interest rate benchmarks. Significantly, in June 2017, the Alternative Reference Rates Committee (“ARRC”), an organization convened by the Federal Reserve Board (“FRB”) and the New York Fed, selected a broad repo rate as its preferred alternative reference rate. In choosing a broad repo rate, ARRC considered factors including the depth of the underlying market and its likely robustness over time; the rate’s usefulness to market participants; and whether the rate’s construction, governance, and accountability would be consistent with the IOSCO Principles for Financial Benchmarks. Continue Reading

On November 6, 2018, the U.S. Securities and Exchange Commission (“SEC”) brought an enforcement action against a (formerly) registered investment adviser (“Adviser”), for failing to meet its diligence and compliance responsibilities under the Investment Advisers Act (“IAA”) relating to certain repurchase agreement (“repos”) facilities it offered to its clients.

The Adviser offered nine repo facilities involving loans guaranteed by various government entities. Under an agreement with First Farmers Financial (“FFF”), FFF purportedly pledged loans guaranteed by the U.S. Department of Agriculture (“USDA”) as collateral for the repo. However, the loans turned out to be fraudulent, and FFF and its corporate officers exhibited a number of red flags along the way, including providing falsified financial statements from a fake auditor.

The SEC found that the Adviser violated various provisions of the IAA and its rules by harming its advisory clients, which included a registered investment company, in two primary ways. First, the SEC found that Adviser failed to pursue the truth about FFF’s repos in the wake of missing audited financial statements and warnings by Adviser employees and a private investigator. And second, Adviser failed to adequately resource its compliance department and did not have or follow compliance policies and procedures that could have prevented the FFF issues in the first place.

Under the SEC’s enforcement order, Adviser must pay a civil monetary penalty of $400,000. The SEC’s enforcement order against Adviser can be found here.

On October 31st, the CFTC’s Office of the Chief Economist (the “OCE”) issued a report about “Phase 5” of the uncleared margin rules (“UMR”) that are slated to go into effect on September 1, 2020. The purpose of the report was “to guide regulators in their responses to industry requests for relief” from the scheduled application of Phase 5.

This post will provide an overview of the main conclusions of the report. Any potential implementation of revisions to the UMR consistent with the conclusions in the report would have the effect of reducing the number of market participants subject to UMR, thereby simplifying compliance processes and burdens on entities that may have otherwise been impacted by the UMR. It is too early to forecast whether regulators will propose and ultimately implement revisions to the UMR based upon this report. Although, we believe that its issuance is a noteworthy development.

At the outset, the UMR are complex and their application to any particular trading activities should be undertaken in consultation with counsel familiar with these rules. This post is not legal advice.